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The term “synthetic” pops up with relative frequency in the options strategy lexicon, so today we’re going to attempt an explanation of the term. Be aware, though – it’s only the beginning. There are a great number of trading strategies that involve synthetic positioning.
What’s synthetic got to do with it?
The term synthetic in options parlance refers to a position that replicates in some fashion an equivalent non-options trading position. As the example below shows, one can, for instance, use options to synthetically create a long stock position. Kind of an equity Frankenstein, but without all the horrific expense.
Let’s examine a synthetic long stock position with a look at a chart of Boeing (NYSE: BA).
Imagine the following scenario. It’s late June and you want to be long Boeing shares. You like the company’s prospects, but funds are tight and allocated elsewhere, so an outright purchase of 100 shares of the stock for roughly $14,000 is not an option. Your broker tells you about a cheap method of creating a long Boeing position using options. He explains as follows:
You can simultaneously buy an at-the-money call option and sell an at-the-money put option on Boeing and create with near precision the same risk-reward profile for owning the stock, but at a fraction of the cost.
You’re from Missouri, you tell your broker, “You gotta show me.”
So he does. And the numbers fall out like this:
With Boeing trading at $140 (red circle), you buy the end of October 140 call for $2.50 and sell the end of October 140 put for $2. Your total debit on the trade is $0.50.
And what happens?
As you can see, Boeing squiggles in the $130 range for well over a month before bouncing toward $150 at expiration. When the trade actually closes, Boeing is at $148 (green circle), your short put option has expired worthless, and your long call is in the money exactly $8 ($148 – $140).
Your net profit for the trade is $750 ([$8 – $0.50] x 100), just shy of what it would have been had you purchased the stock at $140 and watched it rise to $148 (an $800 gain).
But what if your luck had been otherwise? What if Boeing had taken a nosedive and crash landed at, say, $130 on expiration?
Again, the results are comparable to the “what-ifs” of owning the stock. Had you purchased Boeing at $140 and watched it drop to $130, you’d have been out $1,000. Going the synthetic options route, the long call would have expired worthless and the put would have been in the money $10, leaving you in the hole $1,050 altogether ([$10 + $0.50] x 100).
That’s only marginally more than the stock ownership route, but when you consider the difference in the initial outlay – $14,000 vs. $50 – it’s hard not to be impressed with the synthetic long alternative.
Important: Know that a short stock position can be “synthesized” by simply reversing the operation and:
- Buying an at-the-money put; and
- Selling an at-the-money call
Good luck!
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